What Is Volatility Skew?
Volatility skew describes the pattern of implied volatility across different strike prices for the same expiration date. In equity markets, OTM puts typically have higher IV than ATM options, which in turn have higher IV than OTM calls. This creates a downward-sloping IV curve called the volatility skew or smirk. The skew reflects the market's fear of downside crashes and the demand for protective puts.
Volatility skew emerged prominently after the 1987 stock market crash (Black Monday). Before 1987, the IV curve was relatively flat across strikes. After the crash, the market permanently priced in higher IV for OTM puts to account for crash risk. This skew persists today and is a fundamental feature of equity option pricing. Understanding skew helps traders price risk more accurately and identify relative value opportunities.
Demand and supply: institutional investors buy OTM puts for portfolio insurance, driving up their IV. Supply and demand: fewer traders sell OTM puts (crash risk), limiting supply. Risk compensation: sellers of OTM puts demand higher IV to compensate for fat-tail crash risk. All these factors create the persistent negative skew in equity markets.
Skew Metrics
- 1Skew = 35% - 27% = 8 percentage points
- 2Skew ratio = 35% / 27% = 1.30
- 3Put skew premium over ATM = 35% - 30% = +5%
- 4Call skew discount vs ATM = 27% - 30% = -3%
- 5Risk reversal = call IV - put IV = 27% - 35% = -8%
- 6Interpretation: moderate negative skew, typical for equities
- 7Put sellers receive 5% IV premium over ATM for crash protection
| Asset Class | Skew Direction | Typical Skew | Reason |
|---|---|---|---|
| US Equities (SPX) | Negative (put heavy) | 5-12% | Crash protection demand |
| Individual Stocks | Negative (variable) | 3-15% | Stock-specific risk, hedging |
| Commodities | Positive (call heavy) | -3 to -8% | Supply shock fears (upside) |
| Currencies | Mixed | Variable | Depends on pair dynamics |
| Pre-Earnings Stocks | Steeper negative | 10-20% | Event risk, tail hedging |
Trading the Skew
- Skew is persistent in equity markets since the 1987 crash
- Higher skew means greater crash protection demand (more fear)
- Skew tends to increase during market selloffs and VIX spikes
- Individual stock skew varies by sector, event risk, and flow patterns
- Skew creates a systematic premium for put sellers (volatility risk premium)
Track skew relative to its own history. If current skew is in the 90th percentile (steeper than 90% of readings in the past year), puts are very expensive relative to calls. This favors put-selling strategies. If skew is in the 10th percentile (flat), puts are cheap and may be good to buy for protection.
While selling skew (selling expensive OTM puts) has a statistical edge, the risk is that skew exists for a reason: crashes happen. The premium earned from selling puts is compensation for the risk of a large, sudden downside move. One crash event can erase years of skew premium collection.